Iron ore price: It's all about grade now
Domestic supply can't be cut much further and Chinese steelmakers are demanding deeper discounts for lower grade imports
Iron ore is down 30% this year and after a relatively quiet 2013, market volatility is back with a vengeance.
The market was jolted on March 10 this year, when iron ore suffered the worst one-day decline since the 2008-2009 financial crisis, cratering 8.3% in a single session.
The recovery from there was swift, but two months later the market was back in panic mode with a quick decline to double digits.
Attempts to breach $100 have been unconvincing. On Monday benchmark Northern China 62% Fe imports gave up more than a percent, falling back to $93.80. That's down from a high of $158.90 in February.
Long held assumptions about the direction and dynamics of the iron ore market are being tested.
The rule of thumb for the industry was for a long time that $120 constitutes a price floor, because if the price stays below this level for too long Chinese miners drop out of the market.
This floor has been regularly marked down and $100 seems to be the new consensus. Iron ore has never traded below $100 on a quarterly basis since 2009.
So far that floor has held – the Q2 2014 average is $102.70.
The outlook for the rest of the year is much murkier however.
The wildcard again is domestic Chinese supply.
China been trying to lessen its dependence on foreign ore for the years, artificially boosting domestic production of iron ore by restricting small blast furnaces' access to high-quality imports.
Domestic output had grown at an almost as fast a rate as imports to peak at some 1.4 billion tonnes or roughly 600 million tonnes on a 62% basis.
China's active program of shutting down excess steel capacity (60 million tonnes by end-2015) and consolidating miners have altered this picture considerably.
Between 20% – 30% of mines in China have closed down, according to the China Metallurgical Mining Enterprise Association.
According to Credit Suisse 62%-equivalent domestic production will decline 16% to 310 million tonnes this year and drop again in 2015 to 275 million tonnes.
On the face of it a decline of that magnitude should create gaps for exporters from Africa, Brazil and Australia.
But the Swiss investment bank has a number of caveats reports investment site Barron's and higher-cost Chinese iron ore producers are closing shop slower than expected
Not all production is at "the top of the cost curve," some mines are captive to mills and state-owned mines "have an incentive structure that rests on more than short-term commercial conditions."
On top of that says Credit Suisse, Chinese miners enjoy flexible costs with some local governments already reducing taxes for some miners.
Despite the downturn domestic expansions are still proceeding with fixed asset investment in Chinese iron ore mining is up 15% this year.
If local production is staying relatively robust supply would have to be cut somewhere else. But Chinese steelmakers prefer imports for other reasons.
Because the ore is of such a low quality – falling from an average above 30% to a only 21.5% iron content – the bulk of Chinese fines require a process called sintering before being fed into blast furnaces.
Sintering adds to the environmental impact and costs which does not fit well with Beijing's war on pollution and plans to eliminate overproduction in the steel sector.
China's steelmakers have been substituting domestic supply with so-called "lump" ore from Australian, South African and South American producers that lower costs and cut pollution by reducing the need for sintering.
Premiums for high-quality lump and pellets over fines reached as much as $17–$18 a tonne and $42 a tonne respectively earlier this year.
A more recent development is the widening gap between different quality fines: 65% fines at Qingdao fetches $103 while Tianjin 58% goes for $26 a tonne less. The discount to 62% has doubled from around $8 at the start of the year to $16 today.
MVS, a research house, is quoted in the FT as saying the "quality spread" has appeared because "there is currently a lot of lower grade product in the market due to the aggressive expansion plans of Fortescue Metals Group."
World number four producer FMG will hit its target capacity of 155 million tonnes per year in 2014, delivering an additional 51 million tonnes in 2014.
Another factor is a lack of high-grade Chinese concentrate to mix with lower quality supply, which has forced steelmakers to move to opt for high grade ore.
The move to higher grade ore may also explain the interest in Guinea's giant Simandou north deposit despite the eye-watering capex required.
Simandou is as easily exploitable as Australia's Pilbara region and top producer Vale's Brazilian home base. Better still, grades are 65%-plus.